Hidden Risks of Robo-Advisors

Maybe you’re thinking about investing with a robo-advisor or are even using one already.   While the idea in principle sounds good, there are some important risks to think about if you’re considering using an online robo-advisor platform.  In this post I’m going to talk about where robo-advice falls short.

1 – No Real Financial Planning

During the signup process, nearly all robo-advisors require that you complete an online questionnaire.  The purpose is to provide a basis for determining your recommended asset allocation.  Unfortunately, these simple surveys address only your most basic financial needs, most notably, the determination of your risk tolerance at this particular snapshot in time. 

Many of these online sites also provide some simple DIY tools to play around with, perhaps illustrating when you will run out of money in retirement under certain very simple assumptions.  While these tools can be useful as a first step, they should not be considered real financial planning.

Contrast the experience of working with a live advisor who knows you.  You will have a deep conversation about your future financial needs and goals.  This will help uncover both your ability and need, to take on investment risk.  With your goals well defined, and a plan to achieve them in place, you will be better equipped to take on the inevitable life events to come.  Financial Planning should be the core of the wealth management experience.

[More on this Topic: Why You Need Real Financial Planning]

2 – No Access to a Dedicated Financial Advisor

At most robo-advisors, there is no way to talk to a live CFP.   The support team accessible through the phone bank and generic support email can answer questions only about your account and does not have the expertise to provide financial advice specific to your situation.  In many cases, they are not even allowed to provide financial advice. 

Recently, some robo-advisors began offering access to an advisor, but odds are, you will talk to a different support person each time that you call.

The true value is in having a dedicated advisor who knows your specific goals and financial situation. 

3 – Exaggerated Claims of Performance

In general, robo advisors seem to promote exaggerated claims of performance.  This usually takes the form of comparing their model portfolio to a generic portfolio.  Overwhelmingly, these are not apples to apples comparisons and are based on past performance.  As we know, past performance does not predict the future. 

I also see some exaggerated benefits of tax loss harvesting.  If you read the fine print on these analyses you will see that these are based on very specific assumptions such as whether the person is in the highest tax bracket today and maintains all of their investments with that robo-advisor. 

Most of the time, tax loss harvesting is best done very selectively and not continuously by an algorithm.  Excessive tax loss harvesting can also cause unintended consequences at tax time including wash sales, which disallow deducting the loss if similar assets are held elsewhere in other accounts.  This also creates unnecessary complexity. 

Depending on life events, such as a temporary drop in income, it may make sense to instead harvest gains!  Since the algorithm is unaware of your personal situation, it could easily do things that no longer make sense for you.

4 – Unknown Behavior During Times of Market Volatility

Do you remember the most recent of the stock market mini crashes we just experienced?  There was one right after the Brexit vote during June 2016, and a one-day flash crash during August 2015.  These things seem to be happening with greater frequency now that almost all trading is done electronically.

Most robo-advisors primarily use ETFs that are based upon indices.  When the stocks in the underlying indices become very volatile or are halted for trading, the ETF cannot be priced fairly and becomes susceptible to market manipulation.  It becomes much more expensive than it should be. 

The last time we had a day with huge volatility, one large well-known robo-advisor decided to halt trading and override its computer algorithm because it could not price the ETFs used in their model portfolio.  While this was the right decision, the real problem is that there is usually no policy to deal with these contingencies in which a human must intervene to stop the algorithm

During the next, and possibly more serious flash crash, will you even be able to log in, or will the site become overwhelmed with user traffic and crash? The truth is that despite what the companies may claim, even the biggest brokerage sites become slow and sometimes essentially unusable when everyone tries to log in on volatile days.  

5 – A Lack of Real Value

We all know robo-advisors tout their low fees, but how low are they really?

When you look under the hood, some robo-advisor fees are not as cheap as they seem.  This is especially true if you have a lot of money invested and a relatively large portfolio.  Consider that you could be paying total fees that are similar to a lower cost but still full-service financial advisor who also includes comprehensive financial planning in their services. 

In other cases, services that at first appear to be “free” cost you money over time.  For example, some well-known robo-advisors allocate a large percentage of cash.  A large cash holding earning essentially zero interest will be a big drag on the portfolio’s performance.  I’m also scratching my head why one would want to pay a management fee, no matter how cheap, to manage such a large cash position that just sits there without ever being invested.

 6 – An Unknown Future

How long will all of these companies be around?  No one knows for sure, but what we do know is that many of these firms are burning through their venture funding at a rapid rate.  There won’t be room in the marketplace for all of them and some will either need to consolidate or shut down in the coming years.    

How will this affect your investments?  Although the actual investments are held by an independent custodian, there is a real possibility that you could experience significant delays getting your assets out if a company suddenly closes its doors. 

Alternatively, some of these offerings may simply need to consolidate with traditional asset management firms or raise their fees.  If this were to happen it would defeat the original premise of the low fees.

Thinking about unplugging your robo-advisor?  Contact me here.

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